The Evolving Structure of the U.S. Treasury Market and its Impact on Incumbent Dealers

 
PHOTO CREDIT THE HILL

PHOTO CREDIT THE HILL

 

A lot is going to change in the next few years for the US Treasury market. Not all of this will be good for the stability and health of the primary funding source for the U.S. government. But the evolving role of primary dealers means that, for many, acting as riskless principals could allow them to increase profitability, while deploying less capital at the same time.

So what do we see in our crystal ball five years from now?

1. The market grows by 20% or more.

Given the present Government deficit and the Treasury’s borrowing program, it is likely that the total outstanding debt will grow close to $3 trillion dollars over the next five years - increasing the size of the overall market to about $17 trillion. In addition, the Fed is likely to reduce its SOMA Treasury holdings which will increase floating supply of available tradable securities. This mirrors a trend that’s been in place for the past five years, during which the market grew 38%.

2. Primary dealers move to a riskless principal model.

The major sell-side participants will benefit from more efficient means to enter and exit trades on behalf of their clients – through electronic markets. That doesn’t mean an increase in market making for the traditional trading desk; but it does suggest that the future holds more profitable, low-touch agency execution services.

3. Trading volumes increase, PTFs employing HFT strategies role uncertain.

The combination of increased supply and normalization of interest rates will likely result in higher trading volumes. The jury is out on whether PTFs employing high frequency trading (HFT) strategies will continue to exert a dominant influence on market dynamics and pricing in benchmark on-the-run issues where they presently dominate. Profit margins for these firms will continue to collapse as competition increases, pitting algorithm against algorithm in pursuit of pennies. In addition, critics of PTFs are gaining ground, concerned about predatory trading and phantom liquidity that contributes to unexplained volatility. A global database of high frequency trading is to be developed over the next three years by economists and researchers, led by the co-director of the Systematic Risk Centre at the London School of Economics and Political Science.

4. Electronic trading dominates.

E-trading is here to stay, but delivery mechanisms and access routes into the market may change as new entrants look to deploy trading protocols other than traditional central limit order books (CLOB) and request for quote (RFQ). This is a natural extension of technological advancements, which will provide a new way to think about execution. Focus on all-to-all trading venues which connect disparate sources of liquidity in markets in both commoditized (on-the-runs) or less liquid markets where the buyers and sellers are hard to bring together at the same time, such as off-the-runs and TIPS.

5. Big Data and AI capabilities expand beyond the PTF community.

Information is power. “Big Data” and “AI” replace “disruptive technology” as the new soundbites for technological innovation. In an effort to measure the value their trading counterparties and improve execution, real-money investors will become more proactive and innovative, leveraging their own data more aggressively. Regulators and official institutions will build more useful tools and smarter algorithms to help identify destabilizing market behavior as the amount of data they collect increases substantially.  With pricing becoming more transparent and available, smarter ways to seek liquidity and optimize execution will be commonplace.

Michael Paulus has over 30 years of financial markets experience in both the public and private sectors, including senior positions at both the Federal Reserve Bank of New York and the U.S. Treasury Department.